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Citi Ruling Could Chill SEC, Street Legal Pacts

Source: WSJ

Posted on 29 Nov 2011

A decades-old blueprint used by many federal agencies to settle charges of wrongdoing with companies and avoid court was challenged by a U.S. judge, in a ruling that legal experts said could have a significant impact on future law-enforcement efforts against Wall Street firms.

In a sharply worded order, U.S. District Judge Jed S. Rakoff rejected a $285 million deal by Citigroup Inc. to settle civil fraud charges filed by the Securities and Exchange Commission as "neither fair, nor reasonable, nor adequate, nor in the public interest."

The deal was agreed to earlier this year, after the SEC accused the New York company of selling investors slices of a $1 billion mortgage-bond deal called Class V Funding III, without disclosing it was betting against $500 million of those assets.

Judge Rakoff, a vocal critic of SEC settlements, dismissed the $95 million penalty Citi agreed to pay as "pocket change" for a firm of its size.

But the focus of his concern was the boilerplate language used in settlements by the SEC for nearly 40 years. This standard formula, in which the firm neither admits nor denies wrongdoing, was "hallowed by history, but not by reason," the judge said.

He said the public had a clear interest in knowing the truth of what happened, while the court could only decide whether a settlement was fair on the basis of admitted facts, which aren't present in pacts where there is no admission of wrongdoing.

There are obvious advantages for Wall Street in being able to settle fraud allegations without making admissions of guilt, as they could be used in private class actions, Judge Rakoff said. "If the allegations of the complaint are true, this is a very good deal for Citigroup; and, even if they are untrue, it is a mild and modest cost of doing business," he said.

But he added it was harder to work out what the SEC was getting from the deal, "other than a quick headline."

"We respectfully disagree with the Court's ruling," a Citi spokeswoman said. "We believe the proposed settlement is a fair and reasonable resolution to the SEC's allegation of negligence, which relates to a five-year-old transaction. We also believe the settlement fully complies with long-established legal standards."

The SEC rejected the ruling, saying it still believed the proposed deal was "fair, adequate, reasonable, in the public interest, and reasonably reflects the scope of relief that would be obtained after a successful trial."

Robert Khuzami, director of enforcement at the SEC, said the ruling "ignores decades of established practice throughout federal agencies and decisions of the federal courts." He added that forcing cases to go to trial solely because a firm refused to admit to wrongdoing would divert SEC resources "away from the investigation of other frauds and the recovery of losses suffered by other investors."

The judge's ruling, depending on how it plays out, could open the door to greater liability for Wall Street firms, increased legal costs for both companies and federal agencies, and drawn-out resolutions to securities cases, according to some lawyers.

Joseph Grundfest, a law professor at Stanford University, said there could be serious consequences if other courts adopted the same approach as Judge Rakoff by refusing to endorse a settlement unless the firm admitted wrongdoing—something "no rational defendant" would do.

"Judge Rakoff's decision will likely be troubling to the entire federal government, and not just the SEC," said Mr. Grundfest, who from 1985 to 1990 was a commissioner at the agency. "By his logic, it's hard ever to support any settlement without a trial. So, will the federal courts be jammed with trials so that judges can know the 'truth' because they are unwilling to accept allegations negotiated in the shadow of a trial?"

Still, other legal experts suggested the SEC had only itself to blame by failing to provide the judge with enough information to make a decision on the proposed settlement.

"Federal agencies learn, sometimes painfully, that you can't treat judges as though they're rubber stamps," said John Coffee, a law professor at Columbia University who said he was a friend of Judge Rakoff.

He said the ruling reflected an increased public questioning of the value of settlements, in which Wall Street firms can resolve potentially serious fraud allegations by paying back a small portion of investors' losses without admitting having done anything wrong.

The ruling could delay some settlements in the pipeline, including a number—like the Citigroup case—that are related to mortgage-bond deals churned out by Wall Street firms in the run-up to the financial crisis, according to people familiar with the matter. They said some firms may want to wait until the standoff between Judge Rakoff and the SEC is resolved, rather than risk agreeing to a deal only to see the settlement go before the same judge and also get rejected.

Citigroup and the SEC face an immediate quandary in responding to the ruling, legal experts said. They said the ruling could be appealed, but this would risk a ruling that would enshrine Judge Rakoff's tough stance for use by other courts.

"The SEC is going to be very worried that, if they appeal this, there's the potential to set a precedent that would restrict their use of the 'neither admit nor deny' formulation, which is their stock in trade for settlements," said Erik Gerding, a law professor at the University of Colorado in Boulder.

The SEC and Citi could instead let the case be decided at trial. Judge Rakoff on Monday consolidated the Citigroup lawsuit with a separate but related case brought by the SEC against a former Citigroup employee. He set the consolidated case for trial on July 16, 2012. But a trial would carry high risks for the firm, which could face higher penalties and a ruling that could be used in private lawsuits, according to lawyers. They said the SEC would also be wary of going before a jury—which could rule against it—on such a high-profile case.

Instead, legal experts predicted the SEC and Citigroup would try to renegotiate their agreement on terms that Judge Rakoff would approve.

"This ruling puts Citigroup in a very difficult position. I think any revised agreement will use very carefully crafted fudge language," Mr. Gerding said.